Posts Tagged banking

An Annuity is a series of equal payments made at fixed intervals for a specified number of periods. These equal payments are denoted by the PMT and can occur at either the beginning or the end of each period. Future and Present Values of Annuity: Future Value of an Annuity can be calculated, where a series of equal payments are made at a fixed intervals for a specific number of periods. The principle applied here is just like Compounding. However, method of calculating Future Value of Annuity differs in Ordinary Annuity and Annuity Due. Similarly, Present Value of an Annuity can also be calculated by using the principle of Discounting, but the method of calculating Present Value of Annuity differs in Ordinary Annuity and Annuity Due. Types of Annuity: Annuity has following types depending on the period of payment.

1. Ordinary/Deferred Annuity:

If the payments of Annuity occur at the end of each period, it is called Ordinary or Deferred Annuity.

Future Value of Ordinary Annuity:

If equal payments PMT is made at the end of n periods, providing a saving of i, then Future Value of Annuity (FVa or FVAn) can be calculated as:

Present Value of Ordinary Annuity:

If equal payment PMT is made at the end of n periods, providing a saving of i, then Present Value of Annuity PVAn can be calculated as:

2. Annuity Due

If the payments of Annuity occur at the beginning of each period, such Annuity is called Annuity Due.

Future Value of Annuity Due:

If equal payment PMT is made at the beginning of n periods, providing a saving of i, then Future Value of such Annuity FVAn can be calculated as:

The only difference between Future Value of Deferred Annuity and Annuity Due is that every term of Future Value of Annuity Due is compounded for one extra period, reflecting the fact that each payment for an Annuity Due occurs one period earlier than Ordinary Annuity.

Present Value of Annuity Due:

If equal PMT is made at the beginning of n periods, providing a saving of i, then Present Value of such Annuity PVAn can be calculated as:

The only difference between Present Value of Deferred Annuity and Annuity Due is that every term of Present Value of Annuity Due is discounted for one extra period, reflecting the fact that each payment for an Annuity Due occurs one period earlier than for Ordinary Annuity.

3. Perpetuity

Some Annuities go on indefinitely, or perpetually, and are called Perpetuities. The Present Value of such Annuities is simple to calculate.

When an investor invests in multiple
stocks/securities, it is called Investment Portfolio. Maintaining a Portfolio
is a very important step taken by investors. By maintaining a Portfolio, Risk
can be mitigated / minimized by maintaining a portfolio and higher margins of
profits can be earned. In this case, if one stock/security defaults, it does
not necessarily mean Investor is also in loss. Instead, investor can compensate
the loss of one stock from other stocks/securities. Fig. 5 shows how
maintaining a Portfolio minimizes the Portfolio Risk. Fig shows that Portfolio
size is taken on x-axis and portfolio risk on y-axis, which results a curved
graph.

Classification of Investors:

Investors can be classified on the basis of their risk-taking/bearing capacity. How much risk an investor bears, depends on investor’s personal capacity, attitude, interest and behavior. For example:

1. Risk Seekers

Risk seekers seek for riskier investment. They are capable of assuming a higher risk and have strong and healthy financial position.

2. Risk Avoiders

They avoid riskier investments, because they have not strong and healthy financial position. They choose those instruments, which have less variation in returns.

3. Risk Bearers

Risk bearers fall in between the above categories. They choose moderate levels of risk they can bear according to their capacity.

Hedging:

Risk reduction is known as Hedging. They do it by using Derivative Instruments.

Security:

A Security refers to a publicly traded financial instrument, as opposed to a privately placed instrument. Securities have greater liquidity than otherwise similar instruments, which are not traded in Open Market. Security is considered to be an insurance against an emergency, according to banking definitions.

Classification of Securities:

The securities have been classified according to the functional operation aspects as under:

1. Intangible Securities

These are personal exclusive undertakings by a party to pay the amount of advances outstanding against a borrower. Examples of such securities are Demand Promissory Note, bill of exchange or a Bond, Guarantee and Indemnity etc.

2. Tangible Securities

These are the securities which can be realized from sale or transfer. Examples of such securities are Shares, Stock, Land, Building and Goods.

3. Prime Securities

These are also called Primary Securities. Such securities are main covers for an advance and are deposited by the borrower himself. When a depositor of term deposits offers his Term Deposit Receipt to cover and advance, it is the Primary Security according to banking term.

4. Collateral Securities

These are the securities provided as an additional cover for an advance, where either he security is not very stable in value, or where the realization of the security to cover the outstanding amount of balance is difficult. In case of the default by borrower, bank has the authority to sell these shares of security and adjust the advance.

5. Movable Securities

These are the securities, which are legally and physically both in possession of the lending bank. Examples are Term Deposit Receipts, Goods, Vehicles and Merchandise etc.

6. Immovable Securities

These are the securities, where the legal possession or right to takeover is entrusted to the lending bank, but the physical possession remains with borrowers.

7. Government Securities

These are the long-term securities issued by the government for financing social programs. They are perceived as Risk-free, are highly liquid and carry attractive coupon rates. Like T-bills (Treasury Bills), government securities are sold through auctions and are actively traded in secondary markets.

Time Value of Money:

The theory of Time Value of Money states that the value of money decreases with the passage of time. This concept can be described as “A Dollar in hand today is more worth of a Dollar tomorrow”. This happens because of Inflation. Inflation is a situation, where the prices as a whole are increasing. The rate at which the prices are increase is known as Inflation Rate. Two terms are necessary to explain while discussing Inflation and theory of Time Value of Money:

1. Nominal Interest Rate/Quoted Interest Rate:

Nominal Interest Rate is a rate at which money invested grows. Banks generally offer Nominal Rate of Interest to the depositors.

2. Real Interest Rate

Real Interest is a rate, at which the purchasing power of an investment increases. Market Interest Rates are Nominal Interest Rates.

Relationship of Inflation, Nominal and Real Interest Rates:

Real Interest Rates, Nominal Interested Rates and Inflation Rates have strong relationship with each other, which can be expressed in the form of an equation:

Financial Markets are places, where Financial Instruments or Financial Assets are exchanged. Financial Markets can be classified on the basis of the nature of instruments exchanged in the economy.

Classification of Financial Markets:

The following are different types of Financial Markets:

1. Securities Market

Security Markets are the Financial Markets, where securities are exchanged. Securities are financial instruments that have been created to represent a legal obligation to pay a sum in future in return for the current receipt of vlue. Securities, thus represent the cash or cash equivalent received from another person. Security Markets can be further classified into National Market and International Market.

1.1 National Market

National Markets (also called Local Markets) are those within the boundaries of a nation. National Markets cater to the financial requirements of the local players. Players from the foreign countries are permitted to bring their financial instruments into the National Market, subject to their following the rules and regulations imposed by the nation. Each nation has a regulatory authority, under whose scrutiny financial instruments are exchanged in that country. National/Local Market can also be classified into Domestic Segment and Foreign Segment.

1.1.1 Domestic Segment

The Domestic Segment caters exclusively to firms registered in a country. The country’s regulatory authority controls the domestic market. Based on the economic performance of the country, the Domestic Markets are also called Advanced Markets and Emerging Markets. Advanced Markets are usually markets in nations that are economically sound and have also progressed technologically. Emerging Markets are those in developing countries, whose economic progress is forward looking. Domestic Market can also be subdivided into Money Market and Capital Market.

i. Money Market

Money Markets are short term Debt markets. Debt is a fixed income security and represents the borrowing of a market player. Money Markets are mostly wholesale markets for financial instruments. Money Market can be classified into the following types:

a) Call Market

Call Market is a money market, and is one, where Call/Notice Money is borrowed or lent for a very short period. If the money is lent or borrowed for a period of up to 14 days, it is called Notice Money. On the other hand, if the money is borrowed or lent for a period more than 14 days, it is called Call Money. Intervening Holidays and/or Sundays are excluded for computing the holiday duration. No Collateral Security is required to cover these transactions.

b) T-Bill Market

The Treasury Bill or T-Bill Market is one, where Treasury Bills are exchanged. Treasury/T-Bills are short term (up to one year) borrowing instruments of the government. They are the lowest risk category instruments, maturing in a short duration. A considerable part of the government’s borrowings happen through T-Bills of various maturities.

c) Inter-Bank Market

The Inter-Bank Market is usually for deposits of maturity beyond 14 days and up to three months. The specified entities are not allowed to lend beyond 14 days.

d) Certificates of Deposit Market

After T-Bills, the lowest risk category investment option is the Certificate of Deposit (CD) issued by banks and financial institutions. A CD is a negotiable promissory note, secure and short term (up to one year) in nature. They are issued and purchased in CD Markets and for a purpose to augment funds by attracting deposits from corporations, high net worth individuals, trusts and others.

e) Ready Forward Contracts (Repo) Market

Repo (abbreviated from Repurchase Agreement) Market is one, where the same securities are sold and repurchased by two parties. This type of transaction is called Repo Transaction according to seller’s point of view and Reverse Repo Transaction from the buyer’s point of view of the security. When seller sells the security with the objective of repurchasing it, it is called Repo. On the other hand, when the buyer of the same security purchases it with a view to resell it, it is called Reverse Repo. This phenomenon can be described as in the following:

Repo = Seller sells the same security + Commitment to Repurchase it

Reverse Repo = Buyer buys the same security + Commitment to resell it

The Future Date and Price are mutually decided by buyer and seller of the same security. Whether the transaction is Repo or Reverse Repo depends on which party initiated it. Two terms are necessary to define while discussing Repo Transactions. Repo Period is the period mutually decided by buyer and seller of the security for which the money is borrowed by the seller by selling it. Repo Rate is the Rate of Interest mutually agreed by seller and buyer for the selling and repurchasing of the same security for a time period (Repo Period) in Repo Market. Repos help banks to invest surplus cash. It helps the investors to achieve money market surplus with sovereign risk. It helps the borrower to raise funds at better rates.

f) Commercial Paper (CP) Market

Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP enables highly rated corporate entities to obtain sources of short-term borrowings and provides and additional instrument to investors. Such instruments are traded in CP markets.

g) Inter-corporate Deposit (ICD) Market

Inter-Corporate Deposit (ICD) is an unsecured load, extended by one corporate to another. Existing mainly as a refuge for low-rated corporations, this market allows a fund-surplus corporate to lend to another corporate.

h) Commercial Bill Market

Bills of Exchange are negotiable instruments drawn by seller (drawer) of goods on the on the buyer (drawee) of the goods for the value of the goods delivered. These bills are called Trade Bills. Trade Bills are called Commercial Bills when they are accepted by commercial banks and are traded in Commercial Bill Market.

ii. Capital Markets

Capital Markets exchange both long-term fixed claim securities and residual/equity claim securities. The main economic role of a Capital Market is to match players, who have excess funds to players, who are in need of funds. These markets can be classified into Debt Markets and Equity Markets.

a) Debt Market

Financial Instruments that have a fixed income claim and have a maturity of more than one year are traded in Debt Market. Debt Market can also be classified into Primary and Secondary Markets.

b) Equity Market

Equity Instrument bestows ownership on the holder of the security. Equity hence implies ownership rights in the corporate entity that has issued the instruments to the public. Equity Market can also be subdivided into Primary Markets and Secondary Markets.

Primary Markets

The Primary Markets are the doorway for corporate enterprises to enter the Capital Market. The issues of new/fresh/subsequent securities are offered to the public through the primary markets.

Secondary Markets

The Secondary Market refers to the exchange of securities that have been listed through the Primary Market. Such markets offer tradability to the financial instruments. Secondary Markets can be subdivided into Spot Markets and Derivative Markets.

Spot Market

Spot Markets denote the currency trading price of financial instruments. In the context of time, the Spot Markets may range between one day, two days or a week. The transactions in the Spot Markets are settled are settled immediately, that is, on the immediate settlement date.

Derivative Markets

Unlike the Spot Markets, Derivative Markets are Futures Market. Trade takes place here with the intention to settle it at a later date. The trade in Derivative Markets is based on Futures Contract, which is an agreement by one participant to either buy or sell a financial instrument at a predetermined date in the future at a predetermined price.

1.1.2 Foreign Segment

Each nation, besides its exclusive domestic market allows firms registered outside the country to participate in its economic activities. This is termed as Globalization or Opening Up of the Economy. This is known as Foreign Participation in a National Market.

1.2 International Market

International Markets are usually referred to as Offshore Markets. This concept includes opening the National Market to other group countries.

2. Currency/Forex Market

The Foreign Exchange or Forex Market is on international currency exchange market. It caters the need of International Mobility of funds. The main players in Forex Market are dealers, who are regulated by the specific regulatory authority of the country. Fig. 3 shows the classification of Financial Markets.

An efficient and strong Financial System leads to the Economic Development of a nation. A country is said to be economically developed, when it has strong Financial Markets and competent Financial Intermediaries.

One of the essential criteria for the assessment of Economic Development is the quality and quantity of assets in a nation at a specific time. These assets can be classified based on their distinct characteristics. Classification of Assets is shown through a diagram chart (Fig. 2):

As we are concerned with Financial Markets, we will focus on Financial Assets.

Financial Assets:

In macro sense, Financial Assets are regulated by the government of an economy. Financial Assets smoothen the trade and transactions of an economy and give the society a standard measure of valuation. Financial Assets also represent the current/future value of physically and intangibly held assets. They show a right on another asset and include Currency Instruments (Cash, Foreign Currency etc.) and Claim Instruments (Debentures, Shares, Deposits, Unit Certificates, Tax Saving Investment etc.)

Properties of Financial Assets:

The following are the properties of Financial Assets, which distinguish them from Physical and Intangible Assets:

1. Currency:

Financial Assets are exchange documents with an attached value. Their values are dominated in currency units determined by the government of an economy.

2. Divisibility

Financial Instruments are divisible into smaller units. The total value is represented in terms of divisions that can be handled in a trade. The divisibility characteristic of Financial Assets enables all players, small or big, to participate in the market.

3. Convertibility

Financial Assets are convertible into any other type of asset. This characteristic of convertibility gives flexibility to financial instruments. Financial Instruments need not necessary be converted into another form of Financial Asset; they can also be converted into Physical/Tangible and Intangible Assets.

4. Reversibility

This implies that a financial instrument can be exchanged for any other asset and logically, the so formed asset may be transferred back into the original financial instrument.

5. Liquidity

Liquidity implies that the present need for other forms of asset prevails over holding the financial instrument. The financial asset can be exchanged for currency with another market participant who does not have immediate cash need, but expects future benefits.

6. Cash Flow

The holding of the financial instrument results in a stream of cash flows that are the benefits accruing to the holder of the financial instrument. However, a financial instrument by itself does not create a cash flow.